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James Pethokoukis is a columnist and blogger at the American Enterprise Institute. Previously, he was the Washington columnist for Reuters Breakingviews, the opinion and commentary wing of Thomson Reuters.

How the Fed just tightened monetary policy

As the US economy deteriorated back in 2008, hawkish statements from FOMC members “effectively tightened monetary policy … by pushing up the expected path of the federal funds rate,” explains Richmond Fed economist Robert Hetzel in The Great Recession: Market Failure or Policy Failure. In May 2008, federal funds futures had been predicting the rate to remain at 2% through November. By mid-June, that forecast had risen to 2.5%.

The same type of thing may have just happened with the release of the minutes from the Fed’s January policy meeting. As Reuters explains, “A number of Federal Reserve officials think the central bank may have to slow or stop buying bonds before seeing the pickup in hiring the bold program is designed to deliver.”

To Paul Edelstein, director of financial economics at IHS Global Insight, those opinions may have “inadvertently” produced a tighter monetary policy by altering expectations:

We don’t expect the Fed to curtail or reign in QE3 next month. There are too many voting members who favor continuing bond buying until the labor market outlook improves. And it won’t improve by March.

But the fact that Fed hawks were able to force a debate on the issue makes monetary policy less effective. This is because markets and the public will question the Fed’s commitment to keeping policy in place until it achieves its goals for unemployment and inflation. If markets do not expect the Fed to stay the course, then expectations for economic growth and inflation will stay depressed and demand for safe assets (cash and government securities) will remain high. Counter intuitively, this means lower long-term interest rates, not higher.

Markets will now adjust their growth and inflation expectations downward. Already, the stock market is down 1% (suggesting weaker growth expectations), gold is off 2.6% (suggesting weaker inflation expectations), and the dollar is up about 0.7% (suggesting stronger demand for safe assets). The 10-year Treasury rate shed a few basis points.

There is little that Ben Bernanke can do to quiet the dissenters on his committee. If they feel that QE3 should end this year, they will express those opinions in public and official forums. But what Bernanke and the majority of Fed participants that support ongoing bond buying can do is to more forcefully signal to markets that they will stick with their original plan and stay the course until unemployment comes down. They didn’t do this enough at last month’s Fed meeting, and the minutes portrayed the Doves as leaning on their back foot in the debate.

Discussion: (4 comments)

So now merely floating the possibility of someday slowing down the flood of new money is an act of monetary constriction? This really exposes the whole farce of trying to juice the economy through artificially set interest rates. Just let the market set the price and be done with it.

The CPI does not calculate the inflation rate correctly. How can you continue to say there is no inflation, food, energy, college tuition, rents, airfare, automobiles, and taxes have all increased while wages have stagnated. Alan Greenspan and Michael Boskin changed the calculation of the CPI to reflect low inflation fueling the credit expansion and lowering the payments to Social Security beneficiaries. The truth is that since America left the gold standard the government has manipulated the economic numbers creating a society based on debt to support higher prices which has destroyed the middle class.

Who cares? A gold dollar needs none of it. Working people control the standard of living, decide what money buys based on what it is, a gold dollar would buy a far higher standard of living. The 1913 Federal Reserve Act legislated the impossible, regulating how much money there is. People decide what money is worth, no one decides how much there is, only fiat money could serve the legislation. Price controls are impossible, the Constitution says regulate money’s value, only a standard of value does it, the Federal Reserve Act is unconstitutional. Abolish the Federal Reserve with full public disclosure of everything to do with it from day one.